Mutual Funds Explained: Measuring Mutual Fund Performance Using a Rolling Average

In a previous post on performance, I wondered if there was a way for investors to measure how well a mutual fund has done. Mutual fund managers often use comparison to less risky indexes as the benchmark for their own performance. This, we all know, enhances how the fund appears to have done. Right or wrong, I suggested that the ultimate guide to performance may lie in the investor; the person in the mirror who must assess their risk, their goals, and their expectations.

Richard Gates, portfolio manager for TFS Capital agrees. Interviewed recently at Forbes, he said: "I think the root of the problem is not really how returns are measured and presented. Rather, I think the basic problem is that investors just shouldn't be so fickle about short-term performance." And that accounting of performance is what we are faced with, almost daily.

The short-term also presents other problems. For instance, how can you tell whether a mutual fund manager simply has lost her/his/their touch even as the market declined for every fund? In other words, is bad really the fund manager's fault? Or is doing bad something entirely different?

It would be nice to throw 2008 out of the equation. But for the next five years, that year will show every fund as underperforming even as we forget about what happened in 2008, probably soon after we turn the calendar on 2010. The real test is how well they have done since March of this year (2009). But that would be looking to the short-term in the hope of finding some long-term potential. Is it possible?

Is it right to do so? Possibly not. If you are an investor, 2008 looked really bad. Yet, never have investors had such a clear understanding of what worst-case scenario looks like. Bear markets toughen investor hides across the board. Sure, many run for cover. But those that understand that bad can be turned into good, relish the opportunity to grab a once in a lifetime (or perhaps once in a five year cycle would be more like it) chance at finding out what worked and what didn't and even more importantly, why.

Keep in mind, even as funds fell, so did their comparable benchmarks. Were they still able to match, even beat those benchmarks in a down year? Did the fund family pursue a cost-cutting, fee stripping strategy to help boost your return, however meager? Did they look out of house for a different manager to run a fund that was really beaten down?

If your fund manager is still at the helm as I write this, look at their performance over the past ten years to get what is called a rolling average. Compare that number with the benchmark's rolling average over the same period. Then compare it to the peer group, using the same investment style as a comparison.

Then look at your risk factor again. The investor in the mirror will need to make some choices as well. And whatever you do, do not eliminate too much risk. Let your fund manager do what he can to mitigate out-sized risk as they struggle to regain your confidence and at the same time, increase their performance.

A Target-Dated Mutual Fund Critic

John Bogle, father of the index fund and founder of the Vanguard Group, keeps his portfolio allocated based on his age, believes that buy and hold is still relevant, and does not feel as though target-dated mutual funds represent stewardship (instead he suggests they represent salesmanship).

Calling what he does the Bogle Age Allocation, he actually believes that Social Security is enough of a bond fund for the average investor. Build your own target-dated fund he tells us largely because he worries that these funds are not what they seem and as I have suggested numerous times, they are as yet proven.

Mutual Funds for the Utterly Confused: Blind Ambition

Sir Isaac Newton once said after a failed investment: “I can calculate the movement of the stars, but not the madness of men.” Do mutual funds change this madness into profits for the average investor? Had Newton invested in a fund instead of chasing an individual investment (like the one he purchased in the South Sea Company) would his money have been safer?

To answer these questions, it is important to understand some of the basics of what a mutual fund is and why it works for those who seek a longer range opportunity and lack the financial savvy to speculate (gamble is actually a better word).

First off, a mutual funds gathers like minded investors to a strategy that employs a manager, a team of investment managers and sometimes even a computer to look at stocks and bonds that fit the goals of its investors. This sounds simple but the "madness of men [and women]" can often play a much larger role in whether this goal is achieved. Mutual fund investors are looking for three basic properties: achievable gains, avoidable losses and control of that mental maniac that wants us to sell on the way down and buy on the way up.

Because funds are populated by the human factor, this madness is not often easy for the fund to control. No (actively managed) fund begins its existence with the goal of losing money. They gather information about investments, take positions in as little as twenty companies and as many as a thousand (often more with index funds, but that is another story) and allow the market to do whatever it may.

Does this mean that you relinquish some control over the day-to-day fluctuations of the market? Yes. And if that is the case, how should you react when the market turns ugly?

The stock market offers the opportunity to gain on the belief that the investment will perform better than it is at the point of purchase. When you buy a stock individually, this gain is realized in plain numbers. Conversely, any losses are also realized in plain numbers as well. In a mutual fund, because there is a huge number of shares in a large number of companies, a gain is diluted (just like any loss).

Unfortunately, mutual fund investors do not always embrace this idea of diversity. They often see the fund's failures as much more individual and its gains as much more muted. If the market surges, and it will, the fund is usually moving in a slower lane, getting there eventually but traveling at a more measured pace. If the market stumbles, and it will and has, investors are reluctant to embrace the possibilities that their investment, because it is diverse by nature, will protect them better than had they invested individually.

The comparisons with broader markets, such an index that tracks 500 of the largest companies, is not well placed. The fund managers have made decision to purchase only a portion of those companies and comparing their efforts against such a broad market is unfair. Yet it is done and often. How your fund performed against an index fund, how much you paid for the services of the fund manager and lastly, how well the fund has sold its philosophy all play a role in how you might react.

Funds have been positioned inside the our retirement plans for a good reason. 401(K) plans offer us the opportunity to invest evenly and consistently over time. This removes the buy on the way up and the sell on the way down problem that plagues individual investor psyche. The approach is called by several names: defined contribution is often used by perhaps more aptly, it is dollar cost averaging.

Once you determine how much of your paycheck will be contributed to this plan pre-tax, you have employed dollar cost averaging. This method uses a fixed dollar amount to purchase shares. Sometimes, when the market is on the rise, you buy fewer shares; when the market is on the way down, you are able to purchase more.

Sounds counterintuitive but it is exactly this method of buying that removes that mental maniac. Had you remained in the fund of your choice when the market was on the way down, made no moves to stop or limit your defined contribution, you will have benefited over the long-term.

But what if you panicked and sold those actively managed fund, opting for something like a target-dated fund, one that readjusts its investment goals over time to account for your age? Did you make the right move? Not necessarily. If you had picked one of these types of funds for the safety it offered, the hands off approach to investing, you would have done well to choose a fund whose target was twenty-years beyond the year you picked.

(Just a reminder about index funds: You will be tempted to use these funds if you know little about the way funds work, But don't. These are tax efficient and belong outside your retirement plan.)